# Episode 99 – The Rules of Real Estate. Part 1

Hi everyone, and welcome to another wise money tools video. I’ve been thinking about doing this real estate video for quite some time now. But a few things happened over this past week or so that has really kind of spurred this. And I kind of want to get this out there because I think it’s really critical, a lot of you might be interested in investing in real estate. So it’s, one of those things that’s going to help you at least, kind of figure out the kind of real estate buyer, you want to be the risk maybe that you’re willing to take, and then how all the numbers work out.

So I’m going to be going back and forth here with my Excel spreadsheet. As we start talking about some numbers, so don’t get dizzy. This is just a 30,000 foot overview. These numbers aren’t you know, perfectly in order just to give you kind of a sense of what you’re looking at, and maybe some rate of return and cap rates and all that good stuff. The first thing I think critical is you got to identify the type of investor you want to be. And by the way, I’ve got some notes here because I want to make sure I hit everything. So forgive me as I’m looking down here. But there’s basically two types of investors if you will, the first one is just a cash buyer, you’ve got cash sitting on the sidelines, you want to buy a piece of real estate or rental property. And so you basically just invest all your cash, no mortgage, you own the property free and clear. And then you just have expenses, taxes, insurance, and so forth.

Then we’ve got to calculate what that means in terms of a rate of return or what’s commonly called a cap rate in the real estate world. cap rates also in stocks, you know, when you’re buying companies, capitalization rate is really what it stands for, but it’s called cap rate, or a lot of people just refer to it as cap rate. So there’s your cash buyer, then you have what’s called a leveraged buyer. This is where you’re using banks or some sort of financing, in addition to what down payment you might have to put. So this is where you’re trying to put in the least amount of cash that you have to and get the most amount of financing for leverage, if you will, so that your rate of return can potentially be enhanced. Okay. So let’s go over just a couple things you’ve got to have a good handle on when it comes to real estate, let’s first talk about equity.

Now, equity is the difference between if you have a mortgage anyway, the difference between what you owe what it could sell for, okay, equity is always the value that you’re going to get if you sold the home. So if you own the house free and clear, and you paid $200,000 for it, now it’s worth 220,000, you have equity of 220,000. But here’s the important thing to understand about equity. Equity gets a zero percent rate of return every day, weekend and week out year after year, forever and ever. Okay, now, let me kind of give you a sense of how that actually works. A home’s value has no bearing on the mortgage that you carry, the only way you get any equity out of a home is what the market is willing to bear.

So if you have a $200,000 house, and you have a $200,000 mortgage, you basically have zero equity. If that house appreciates in value $20,000 now you have 20,000 in equity, but it didn’t matter if you own that house free and clear. Or if you had a mortgage up to the eyebrows. Equity was only produced by market value. So I’m probably getting a little in the weeds here. The point is, is that the only thing is going to create the equity is the market appreciation or if you do have a mortgage pain down your mortgage, but the home itself, its market value has no bearing on how much mortgage or no mortgage that you have asked Hello. Little more than then I wanted to do on this quick little thing. But anyway, okay. Now there’s some factors that you got to consider about money. OK, so the mortgage, this is often called OPM or other people’s money.

This is the lien or the cost that it’s going to take for you to use someone else’s money, the down payment, often referred to as the skin in the game. So most mortgages this today, if it’s a conventional mortgage, you’re going to need about a 20% down payment to buy a home by a half million dollar home, you need $100,000, okay, then we got to factor in if this is a rental with a rental or lease rate is going to be for your income. And then we want to factor in expenses. So all those things go into this bucket, if you will. And we’ve got to figure out is this a worthwhile investment. Once we know what we’re paying, what the rent or lease income will be, what our expenses will be, if we’re going to carry a mortgage or not, then we can start to compute and figure out cap rates or our rate of return, or our rate of on investment. Okay.

So what I think is good idea is to look at real estate, no different than you would look at a stock for instance. So using Warren Buffett as our example, because we love the way he invest. When he looks at a business. He looks at it based on cap rates rate of return, what we also call payback time, he does the same thing with real estate. Now, just because he has cash, this is what’s really critical, especially right now in our current economy, just because he has cash does not mean he’s going to be an investor. Okay, he’s still a very patient investor, waiting for prices to meet his criteria, if you will. So one of the first things you want to assess is this a good time to even be buying into real estate. Are you getting paid for the quote unquote, risk that you’re taking? And if not, then maybe the best thing to do is to still sit on the side lines.

So again, just because you have cash, doesn’t mean it’s going to be working for you better if you happen to be buying into a high priced economy, and then it adjusts. Okay. So using really strict rules of rate of return or payback time, is just absolutely critical. So what are your investing rules? What is it that would intrigue you to invest your money, what rate of return seems reasonable for the risk, and again, assessing where you are in your particular area, in terms of what the market is willing to bear See, right? Like right now Canada is out of control, you’d be lucky to get a two or 3% cap rate there. And what that means is, if you invested $100,000, you’d be lucky to get 2 or 3%, or 2 or $3,000, in return on that hundred thousand dollars, so that cap rates are just ridiculous.

Now, just for those of you who may not understand where a normal cap rate is, or you’ll find that most investors like real estate at about a 10 cap, which just basically means again, $100,000 invested, these are getting $10,000 a year off of that investment. That’s a good rule of thumb, maybe you’ll take a little less, maybe you want a little bit more kind of just depends again, on what’s going on in the markets and so forth. Okay, so oftentimes, when markets get peeking out like they are, you’ll hear analysts talk about the new norm. And I remember this back in the 90s, with the.com, boom, and people were paying huge price earnings ratios.

Basically, a lot of times like Yahoo at one time was, you were paying 2,600% in more than the earnings were actually they didn’t have any earnings, they just had to pick some kind of number, but basically 2600 times earnings. So in other words, if Yahoo was making a buck a share, people were paying 20 $600 for that share, and at a buck a share over it would take 2600 years to get your money back. So obviously, they were counting on some appreciation there. Anyway, the idea is, we want to definitely be looking at what’s normal. And if we’re getting convinced that the new normal is worth buying into. And I don’t again, I don’t know what it’s like in your area. But in real estate that can happen often where people are saying, well, we used to be able to get 10 or 11% cap rate. But now the new norm is 5 or 6% cap rate, that’s where it gets a little iffy, because we’re convincing ourselves to buy into investments or real estate.

In a situation, that’s not all that productive for us in the long run. And when eventually things come back to the mean, that’s what can hurt us. And that’s what happened to those who were buying.com, those who were buying a lot of real estate, and subprime mortgages in 2006, 2007 it all came back to the mean, and there’s a lot of people who got hurt. So don’t let a new norm for you. Because oftentimes, there really isn’t a new norm, it’s just got to adjust back to the mean, hats at some point. Okay, so let’s jump into a few numbers here, just so you can kind of see what I’m talking about. So we’re going to assume you’ve got quarter million dollars to invest, and it’s sitting there in cash. And again, the first thing you have to determine is, are you going to be an all cash buyer use no bank financing? Or are you going use bank financing and leverage your cash.

So thisjust actually happened with a client of mine, they sent me an email and said, Hey, we’re looking at this piece of property, it’s a rental property, can you kind of give me your opinion. And one thing I always tell our clients is we’re happy to help them look at and look through these numbers, we don’t want to tell you what to do. But we definitely want to be if you would like us to be a second set of eyes, just saying, hey, this looks good. Or maybe here’s some things to be concerned about. Anyway, so this is a real life situation, they were faced with this rental, that was $240,000. And the monthly rent was $1495. So the annual rents on this would bring in $17,940 a year. And we’re just estimating between insurance taxes, maintenance utilities, this is probably a little low, but $1,000 for that.

And again, the older the home, and you might need to be setting aside a lot more for maintenance and so forth. Anyway, so the net operating income or in Oh, I was $16,940. So the cap rate on this, basically, this is just taking your net operating income, and divided into the price you’re paying was 7.06. So right off the bat, you could determine Okay, this is a 7% cap rate 7% rate of return, is that worth the risk? Is that worth being called at midnight, because the toilets clogged or the roof, you know, getting a leak in it. So you got to kind of say to yourself, hmm, if the median is where so many investors are at 10%? Is this worth getting into at 7. So now one of the other factors we need to put in there is what could potentially happen on equity appreciation.

So if all this did was never, if all we did was buy this house, take the rents and and have some expenses along the way and earn 7% we’d have to determine if that’s worthwhile, but we’ve got a one other factor and that is homes typically appreciate in value, get this equity appreciation through and 3%. They’re just for fun. It’s probably about right, some homes around the country or 5%, summer less excusing three, that means that over that year’s period of time, we’re gonna pick up $7200 in equity appreciation. And if we add that to the net income, then we’ve got a total appreciation plus net income of about $24,000. Now all of a sudden our return on investment which is cash plus equity is closer to that 10%. But here’s the danger, you say okay, I can get 10% between cash and equity, but you’re relying on that property to increase in value. And it may or may not.

So that’s kind of a risky proposition to assume that that’s going to happen year in and year out for as long as you on the property. So now that’s a cash buyer. Okay, so what if we became a leveraged buyer, in other words, we’re gonna put down a minimum amount to say 20-25%. And we’re gonna borrow money from a bank and finance the rest of it. So that would look something like this. So again, we know the numbers, we’re going to pay $240,000. But we’re this time over here, we’re gonna mortgage $192,000 closing costs about $6638. So we’re going to bring $54,000 to the table, the mortgage payments going to be $1325, or annually $15900. So now our cap rate on cash invested is 2.11%. Again, equity appreciation is where we’re going to get a little bit of leverage, because we’ve put a lot less money down.

Now all sudden our ROI on cash and equity is over 15%. So we do a little bit worse, because we’ve got more costs when it comes to financing. But we do a little bit better, because we’ve got less money in there. And the homes appreciating again, whether we have a mortgage or not the homes going up by that $7200. So if we think we’re gonna get some equity appreciation, then leveraging our money into a home can make a lot of sense. Again, if you think that that’s going to happen, but that’s the risk you take when you’re relying strictly or for the most part on equity appreciation, because the numbers just don’t look all that great with a mortgage at these mortgage or excuse me at these rent rates. Okay, we went a little long there, but this is good stuff. And what I want to do is continue on the next video, our conversation here.

If you have any questions, make sure you shoot them to questions at wise money tools.com. If you want to do a strategy session, click on the link below and set up a time to have a conversation with me for a few minutes. Never miss a video, so make sure you subscribe. And in the meantime, you have a great week, and I’ll talk to you next week. Take care.